Real estate debt: today's alternative for the income-seeking investor?

Non-equity tranches of the real estate capital stack may provide welcome opportunities in a challenging context of high property valuations and the potential of rising rates.

Real estate valuations have reached historical peaks. For many investors, especially traditional core equity real estate investors, this may mark a challenge.

Core real estate is known for its regular income yields – cash flow patterns most akin to a fixed income investment. Today, this coveted income comes at a high price, and potentially high risk in certain markets which have been heating up, seeing valuation hikes. What then?

For some investors, a ‘wait and see approach’ has been the answer – 2016’s global transaction figures were severely down from the previous year’s. For others however, the attractive solution is to look to other parts of the capital structure. Investing in real estate debt today, particularly the mezzanine tranche, may represent a means to attain similar cash flows to core equity plays, but at lower prices and with greater downside protection.

While mezzanine lenders may reap returns from multiple sources including current coupons, upfront and exit fees, PIK and equity kickers; they can control the rights associated with their position and appropriate the asset as owners in the event all turns sour. At the same time, today’s debt markets reveal a far healthier image than that of a decade ago – improved debt service coverage figures, stricter covenants, and lower loan to value (LTV) ratios that ensure a deeper equity cushion in the event of a downturn.

This means that partnering with real estate experts able to accurately price properties and reposition them in the event of foreclosure is crucial to the success of this investment strategy, as is a focus on opportunities in lender-friendly jurisdictions (US and Northern /Western Europe).

Source: Trepp Dec. 2014; Bloomberg, Morgan Stanley Research; Oaktree Sept. 2015

Scramble for private equity co-investments

Don’t be blinded by the siren call of co-investments, these transactions require the best of analysis and significant resources to succeed.

The appeal of co-investments is undoubtedly strong. Co-investments are a great way to boost returns, shape one’s portfolio, access unique opportunities at lower fees, and accelerate a portfolio’s capital deployment.

Co-investing is resource intensive, requiring due diligence expertise and efficient decision-making processes to allow investment decisions to be made within the notoriously tight timelines designated by GPs. While many LPs advertise their motivation to co-invest, few are actually able to deliver. LPs are faced by headwinds of typically tight timelines, adverse selection risk. In the end, there is nothing to prevent a co-investment - in which an LP has a direct and relatively outsized exposure - from being an underperformer.

That being said, a skilled, selective manager should also be able to pick their way through the rough (Pictet’s loss ratio since 1992 is 2.2%). In a context of diminishing returns in recent years, investors continue to climb the risk ladder and co-investing looks set to be in fashion for a while to come.

Source: Preqin Investor Interviews, June 2016

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